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February 10, 2006

Lionsgate Messes Up Again

I was wrong on Lionsgate (LGF). Big time. The company missed its 3Q06 earnings badly with EBITDA, net income, and free cash flow all falling well short of estimates. The company lowered guidance for each of these items for its full year which ends on March 31. The lowered guidance implies that 4Q06 results should actually be fairly close to current estimates. However, with revenue performing in line to better than expected every quarter this year, it is clear that the business model is under pressure as operating margins are much weaker than expected. This makes it tough to have confidence in the FY07 outlook and will lead to a sharp compression in the multiple that is well deserved. I expect the shares to decline to 15-20% this morning....

The miss is being attributed primarily to home video, especially family and direct to home titles. There is also a hit due to a bankruptcy of a major customer and the expensive, but successful and worthwhile, effort to gain Oscar nominations for Crash. In general, the content side of the house looks like it is performing OK as new theatrical releases and TV shows are performing fairly well. However, the flow through of these businesses to EBITA, net income, and free cash flow continues to lag. In fact, the press release, says that there will be "at least" a one to two quarter lag before the success of recently successful theatrical and DVD releases flows through to the benefit of shareholders. I am troubled by the "at least" qualifier as it could indicate that management is not confident that the deterioration in margins has run its course.

In theory, the shares should have downside protection due to LGF's takeover potential. However, the lowered free cash flow forecast, poor performance of the company during FY06, and the apparent deterioration in the profitability of the company's business model suggest that the takeout price would be significantly lower than I previously expected.

The only hope for the shares in the near-term is that large institutional shareholders, several of which own over 5% of the shares agitate aggressively and pressure management to put the company up for sale. Management will resist and say that now is a bad time to sell but I don’t think shareholders would provide any support for management at this point. It would be quite ironic if another company made a raid on LGF and tried to buy it cheap as this has been a tactic that LGF itself has used on others, most recently Image Entertainment.

I expect the damage to the stock this morning to be severe so I plan to listen to the conference call, which will be going on when the market opens, before deciding whether to dump my remaining shares. Presently, I am leaning heavily in that direction. Very near-term rebound potential seems low and I will be able to make a more rational decision on re-entering the shares if I don’t own the shares.

I'll post more in the earnings summary after the conference call.

Posted by Steve Birenberg at February 10, 2006 12:59 PM in LGF